What Policy Challenges will Arise?

The patterns of investment, saving, and capital flows through 2030 will affect economic conditions from the household level to the global macroeconomic level, with implications not only for national policy makers but also for international institutions and policy coordination. The rapid growth in cross-border capital flows in the decades ahead will make the world’s economies more integrated than at any time in history. Eight main policy messages stem from the three chapters in this report:

National policy makers seeking to support investment activity in their economies should concentrate their efforts on establishing a favorable investment climate. Taking steps to improve the development of the financial sector and adjusting policies to raise the overall quality of governance can be effective for countries seeking to sustain high rates of private sector investment. This is not to say that public investment is irrelevant, since there may be a role for intervention where market failures are clear and where social returns are especially large. If policy makers do decide to pursue the interventionist route with regard to investment policy, attention should be paid to the institutional design. High levels of accountability should be maintained, and interventions should, for example, have a clear sunset clause.

Policy makers will have to recognize the forthcoming increasing demand for services and facilitate the needed accompanying investment. In many developing countries, governments currently engage in policies that, directly or indirectly, favor investment in agriculture and manufacturing while maintaining a protectionist stance in the services sector. Many economies, for example, explicitly prohibit foreign direct investment (FDI) in certain “sensitive” or “strategic” services. Such policies will become an increasing burden on efficiency in a global economy where services account for a larger share of output. Furthermore, if targeted interventions in investment are deemed desirable, the services sector is likely to offer the most social returns in areas such as education, health care, and infrastructure.

Financingforinfrastructural projects will pose a major challenge. Infrastructure needs will have to be financed in a challenging environment in which demographic pressures will exacerbate public sector funding difficulties. Infrastructure financing is particularly challenging given the long-term nature (and associated risks) of these investments. Moreover, as developing countries comprise a larger and larger share of the world economy, they may outgrow traditional sources of infrastructure financing, such as lending by international financial institutions. To meet their future infrastructure financing needs, policy makers in developing countries will need to leverage private sector financing through public-private partnerships as well as tap structured financing from global capital markets.

Governments will have to sustainably manage public finances with an eye toward the forthcoming demographic changes. A large increase in the share of population past working age, in combination with increased demand for health-care services in the later years of life that will come with rising incomes, will strain budgets. The shift in the composition of public expenditure toward health care and pensions will be offset only marginally by the expected impact of aging on education spending. Furthermore, in most developing countries, the scope for decreases in non-age-related expenditures is quite limited. Complex policy challenges will arise from efforts to keep the public burden of health care and pensions under control while limiting the decline in benefits and services. In the face of unprecedented aging, for many developing countries, the public pension and health-care models pursued in the past will no longer be viable options. Looking forward, part of the policy challenge will be to transition to systems with greater participation by private markets.

Demographic shifts due to changes in household structure will increase the importance of financial markets in providing for income support during old age. As incomes rise, household size tends to fall as workers are more geographically mobile and older individuals are more able to live independently on their accumulated savings. Alongside this reduction in household size tends to come a profound transformation of the old-age support structure away from an informal, multigenerational household system to more formal private pension or public social protection systems. Greater reliance on privately financed pensions rather than household savings and transfers during old age has the potential to improve welfare, assuming that the elderly and their children all prefer to live separately. Another benefit is that using private financial markets to intermediate pension savings can increase financial depth and contribute to development. However, shifting from dependence on the income of family members to dependence on financial institutions also underlines the importance of strong regulation to limit fraud and excessive risk taking among financial intermediaries.

Policy makers in developing countries have a central role to play in boosting private saving through policies to raise educational attainment, especially for the poor. This is likely to reduce saving concentration observed across household groups within countries. Indeed, such concentration also has negative implications for economic mobility and thus for the political and social cohesion essential for growth. Not only do high-income households tend to save a greater proportion of their incomes than low-income households, but they also account for the bulk of savings in countries at various stages of development and demographic transition, although to different degrees. In countries with high economic mobility, the relationship between low savings and low income could reflect efforts to smooth consumption by households experiencing temporary income losses. Unfortunately, a similar correlation is observed across households grouped by educational attainment, a proxy for permanent income and thus a more stable condition than the position in the income distribution at a point in time. Consistently, the least educated group in a country has low or no savings, suggesting that those individuals have an inability to improve their earning capacity and, among the poorest, to escape a poverty trap.

The course of global monetary and financial policy making will need to be adjusted as developing countries become responsible for an expected half or more of the world’s capital outflows. Both the gradual and rapid convergence scenarios envisage that developing countries will account for a substantially increasing share of the world’s gross capital inflows and outflows through 2030. As growing amounts of capital are transferred among developing countries, South-South monetary policy coordination will become more critical in promoting stable financial and macroeconomic conditions in these countries. In particular, there is capacity for greater regional monetary policy spillover from large emerging economies such as Brazil and Russia. At the global level, greater use of the renminbi could considerably strengthen the impact of China’s monetary policy on the rest of the world, partially eroding the dominance of Euro Area and U.S. monetary policy. For small and medium-size developing countries, a world with a multipolar currency hierarchy would mean that developing countries will become less affected by monetary policy spillovers from any one country. This could be stabilizing on a global level because liquidity shocks will be more diversified, but it could also become more difficult to assess the timing and extent of monetary policy spillovers, requiring greater monetary policy coordination. Regardless of the currency composition of capital flows in the future, the increasing share of global flows going to and from developing countries indicates that these countries should have a larger role in management of capital flows at the international level, within both bilateral and multilateral organizations.

Policy makers will need to prepare for a greater role of capital markets in international financial intermediation and promote the development of domestic capital markets.Looking forward, as gross capital inflows and outflows grow in scale, their composition in terms of portfolio, bank lending and foreign direct investment will also grow in importance. This is because these different types of flows have different implications for macro stability.It is likely that, globally, capital markets will intermediate a growing share of flows in the future and that banks will account for less. Bank lending tends to be highly procyclical and generally less supportive of risk sharing than FDI or equity portfolio investment. However, total (debt and equity) portfolio investment has historically been even more volatile, in relative terms (that is, adjusting for the smaller magnitude of this component of developing countries’ inflows), than bank lending. Moreover, as households and firms in developing countries increasingly demand not only greater access to credit but also greater choice and variety in financial assets and services, domestic financial markets will have to compete globally in terms of both their structure and their depth. Although the many efforts under way to improve regulation of the international banking sector will remain highly relevant, policies should also be designed to accommodate—and in some cases actively promote—the development of domestic capital markets. At the same time, authorities should monitor the composition of both capital flows; more broadly, they should develop regulatory institutions to be forward-looking and ready to adapt to potentially destabilizing changes in the composition of capital flows.